Financial modeling for startups: the top 10 mistakes!

Financial management

Financial management

Financial modeling for startups: the top 10 mistakes!

Goort de Bruijn and Wout Bobbink, 7 December 2018

Whether you are applying for a loan at a bank, trying to convince an investor of the potential of your firm or are applying for a subsidy or grant; in most if not all cases you will need to provide your counterparty with a financial plan.

Your ability to raise funding can make or break your company, so when you are engaging with financers you want to be well prepared. Therefore it might be a good idea to check your financial model against the following ten common financial modeling mistakes. These are identified during several years of supporting startups with their financial projections by the Finance Navigator team.

Mistake no. 1: mismatch between the financial model and the business model

The financial model is oftentimes part of a greater business plan including for instance a pitch deck, investment memorandum or overall business plan. Together these documents provide information on the team, value proposition, technology, market, milestones and competition of your specific business. Your financial projections should translate this information to financial and hence measurable values. One could therefore argue that the business plan and financial model are two sides of the same coin.

Claims you make in your business plan should resonate with your financial plan and vice versa. When you for example plan to launch your product in 2019, you would also expect significant sales and marketing costs in that period. When introducing a second generation of your product or service the year after, your financial projections should likely reflect new cash flows and price changes. When competition is fierce and requires you to continuously improve your product one would expect significant research and development costs. Unfortunately it is not uncommon that we find financial models by startups which do not reflect the organization’s strategy.

To use the words of Guy Kawasaki: “Your job is to create a numerical framework that complements and reinforces the vision you’ve painted in words”.

Mistake no. 2: overoptimistic or pessimistic revenue projections

It is difficult to strike a balance between optimism and realism. On the one hand you do not want to be perceived as the cowboy who thinks he/she will generate hundreds of millions of revenue within just a couple of years. On the other hand you do want to present an attractive business case, especially when you aim to attract venture capital. Also important to keep in mind is that once you do lock in that investment, your financial forecasts become your targets. It is a sure bet that investors will hold you responsible for reaching those targets. Therefore you should always question whether your forecast is achievable.

Hereby we provide you with two tips:

Find an investor that suits your business case. E.g. a subsidy provider is mainly interested in whether your plans are in line with the goal of the subsidy fund (such as the development of innovative technologies or increasing employment). Banks might not require very ambitious plans either, but are more interested in whether you are able to repay the loan and interest costs. Because of that reason banks prefer to finance working capital, inventory or capital expenditures such as machinery and buildings. On the other side of the spectrum we have angel investors and venture capitalists who look for steep growth curves in terms of both sales and profits, to cover for the risk they take in financing early stage companies. This makes them particularly interesting for high growth potential startups and scale-ups.

Combine the top down and bottom up approach when building your revenue forecast. Use the bottom up method to arrive at a monthly operational budget for the next 12 (perhaps 24) months and use the top down approach to show your long-term growth ambitions. You can find more information on top-down and bottom-up planning here.

Mistake no. 3: the funding need is not adequately explicated

For what reason do you actually need funding? If it takes you more than a few seconds to answer this question you are in trouble. (Potential) investors want to know precisely what you want to do with their(!) money and what you plan to achieve with it. So ask yourself the following questions:

Which milestones do I want to achieve and when?

What activities do I need to undertake in order to arrive at these milestones?

What are the costs of executing on these activities?

When you are able to answer these questions you are also able to compose a break-down of your investment need, to clarify what you aim to achieve with the respective funds and to explain when you will reach your milestones. On the basis of this information an investor can determine whether your firm is an interesting investment opportunity.

Always try to step in the shoes of a potential investor and ask yourself whether you are offering an attractive business case for that particular type of investor. If you want to raise €800,000, but will only hit €1 million in revenues in five years from now, it is a waste of time to approach venture capitalists or angel investors.

Mistake no. 4: underlying assumptions are not clear

Maybe even more important than the numbers in your financial model are the underlying assumptions. As mentioned earlier your financial plan should reflect your business plan, meaning you should be able to explain the story behind the numbers. Generally speaking investors are not interested in the detailed precision of individual numbers. They focus on the predominant cash flows within your organization and want you to display sufficient knowledge of your numbers and the financial management of your company. You should therefore aim to create an attractive, yet credible story in which you showcase your knowledge and experience.

You could even consider an investor’s review of your numbers as a mini due-diligence of your business and your entrepreneurial competences. Your assumptions help you survive this mini due-diligence. It is therefore useful to keep track of your assumptions. This can be as simple as creating a Google Drive folder in which you store your supporting and underlying documentation. Think of all the materials that validate your numbers, such as: historical financial information, annual financial statements (if you have those), competitor analyses, market analyses, (supplier) contracts, letters of intent with potential customers, website visitor analyses, invoices, and so on and so forth. In case an investor might require a ‘real’ due-diligence (which sometimes occurs), you are automatically well-prepared.

Mistake no. 5: not (nearly) enough employees

This mistake is closely related to mistake number 2: not only the revenue forecast is often far from realistic, also the personnel forecast is regularly too optimistic. More than once we have reviewed financial projections in which an entrepreneur expects to generate millions of revenue within a few years with a team comprising just the founders and sometimes some developers. Make no mistake, no matter how scalable your product or service is, you will need to invest significantly in sales and marketing personnel if you have the ambition to build a million dollar business in just a couple of years. Add your production staff, research and development employees and back office support and your team will grow even bigger.

To test how realistic your personnel forecast is, you can divide your projected revenues in a given year by the amount of planned employees (‘FTEs’ or full time equivalents) for that year. This tells you how much revenue you expect to generate per employee and provides a solid basis for comparison with competitors and industry leaders.

When your revenue per employee is at a similar level of the top twenty tech companies already in just a few years (see the graph below), this is a strong indicator that you are too optimistic regarding your expected revenues or that you might invest insufficiently in personnel.

Also make sure you take a good look at your personnel costs. When you have just started your own company, it is unwise to grant yourself a high salary from the first day onwards as this is not what investors are looking for. Moreover, be careful you do not underestimate the cost of skilled personnel. For best in class personnel you will compete with industry leaders that have much deeper pockets than you. It is therefore good to think about salary alternatives such as employee stock ownership plans (ESOPs). These might enable you to attract talent without having to pay extremely high salaries.

Mistake no. 6: revenue forecasts which are not aligned with the market size

Many entrepreneurs adopt the TAM/SAM/SOM model to estimate the size of the market and the targeted market share. TAM (total available market) represents the total worldwide market without considering the niche market you are targeting with your product or service. SAM (serviceable available market) provides you with information on the market considering your geographical reach, your type of product or service and (niche) clients. SOM (serviceable obtainable market) is the percentage of SAM which you estimate you can acquire as market share within a reasonable timeframe.

Since SOM represents the percentage of market share you aim to capture, it should be equal to your revenue forecast. Do you mention somewhere in your business plan, investor memorandum or pitch deck the percentage of market share that you hope to acquire then make sure that this is reflected in your revenue projections.

If you want to know more about the TAM/SAM/SOM model have a look here.

Mistake no. 7: operational expenses that are being left out

Besides revenue forecasts also operational expenses are estimated too optimistically in many cases. Costs are oftentimes forgotten or are not aligned with the overall business plan. Short example: when your sales strategy is mainly dependent on online marketing you would also expect significant costs related to online marketing.

If you take some time to search the web you will easily find some lists of typical operating expenses for startups. Check which costs might also apply to your business. There is no need to include every post stamp in your forecast, but make sure that you include the most significant cost drivers for the growth of your firm (such as the marketing costs in the aforementioned example).

While you’re at it, check whether you are not including operating expenses as direct costs or vice versa as this will affect your gross margin. For an overview of definitions of direct costs and operational (indirect) expenses you can check out this article.

Mistake no. 8: operational expenses which are misaligned with the forecasted revenues

Number 8 is perhaps more of a tip than a common mistake. When you are in doubt whether you have avoided the pitfalls mentioned under mistake seven above, you could check whether your operational expenses are corresponding with your forecasted revenues. This can be done by dividing your operational expenses over several main categories for a given period, which are then represented as a percentage of the expected revenues. Categories you could use are for instance: sales and marketing, research and development, and general and administrative.

Doing this exercise might help you find out that you are spending 10% of your revenues on sales and marketing in a given year. When this percentage decreases in the years therafter while your revenues increase significantly this could mean that you are not investing enough in marketing and sales during these years (because how else are you going to realize the revenue growth you are projecting?).

Additionally, you can simply search the web for industry averages and the expenses of industry leaders for comparison purposes. Here you can find the sales and marketing expenses as a percentage of revenues for a number of large technology firms.

Mistake no. 9: no realistic view of margins

Margins are crucial indicators for the performance of your firm. Think of for instance the gross margin, EBITDA margin, and the net margin. It is hence crucial to have a clear view of your current and your expected future margins as they provide you and potential investors with key information about your organization’s performance.

Moreover, margins lend themselves for comparisons against competitors and industry averages. And no worries: your margins do not have to outperform margins of established companies now already (as a startup you are only just getting started), but you should aim to achieve competitive margins in the long run. Here you can find an overview of margins for different industries within the U.S.

Keep in mind that your gross margin should typically improve when your business expands. This is due to a better bargaining position with suppliers and the potential of spreading out fixed costs over more products or services (called ‘economies of scale’). This is why the gross margin generally shows a positive trend over time for thriving businesses (especially within the manufacturing and trade industry). This should be reflected in your financial model.

Mistake no. 10: disregarding the importance of working capital

Working capital is the capital that you need in order to sustain your daily operations. In order to assess your (future) liquidity you should not only steer your company based on revenue targets, but also on your cash flows. Forecasting for cash flow provides you with an overview of the timing of incoming and outgoing cash flows.

Why is this important? Well, when you focus only on costs and revenues and not on the timing of receiving and sending payments you could end up in serious trouble. Consider that a large firm orders one hundred 3D printers at a startup producing a new type of 3D-printers. The client expects the printers to be delivered within one month. As large firms often use long payment terms it might take up to 90 days before the startup receives the actual payment for the order. This means that our 3D-printer startup needs to finance the raw materials and production process itself. After all, the company has to deliver within 30 days, but still has to wait for 90 days before the payment is received. If the funds required for production are not available for the startup then the order might be cancelled leaving both parties unsatisfied.

Fortunately there are alternative ways to cope with a shortage of working capital (such as factoring as explained in section 8 of this article). However, when you start approaching investors it is clever to include potential shortages in working capital in your investment need to avoid finding out afterwards that you run short of cash.

Never blunder again!

So: next time check your financial model against these ten mistakes, before you hit ‘Send’ and share all you financial information with a potential investor. This could save you a whole lot of discussion. And headaches as well. Want to learn more about financial modeling? Check out our ultimate guide to financial modeling for startups!